RDP 8905: Monetary Policy Instruments: A Theoretical Analysis 1. Introduction

A central question in monetary economics concerns the appropriate choice of the monetary policy instrument. Reduced to the simplest terms, this can be characterised as a choice between two possible instruments: the interest rate and the money supply. In an influential paper, Poole (1970) discussed the criteria for choosing between the two types of instrument, and concluded with a simple policy prescription. When the money demand function is relatively stable, it is better to control the money stock; otherwise, the interest rate instrument is superior. This distinction has considerable practical relevance. Many central banks have recently moved away from targeting monetary quantities on the basis that money demand functions have become less stable than was previously thought.

Poole's analysis had a number of deficiencies which have subsequently been discussed by other authors. In particular, it used a static model with fixed prices, thus ignoring questions of dynamic stability, and also ignoring the role of monetary policy in determining the price level. These problems have been strongly emphasised by critics of the interest rate instrument. It has been pointed out that certain kinds of interest rate setting behaviour are dynamically unstable, or leave the price level indeterminate. The classic illustration of this is the case of a fixed nominal rate: in this case, any tendency to excess demand will be self reinforcing, since it will tend to raise expected inflation, thus lowering the real interest rate. In rational expectations versions of the argument, this dynamic instability often collapses to indeterminacy in the current period. Sargent (1979), in his widely-used textbook, provided a somewhat extreme summing up of the problems associated with interest rate rules, concluding (p. 362) “there is no interest rate rule that is associated with a determinate price level”.

A careful reading of Sargent's analysis shows that it actually refers to the case where an interest rate is the ultimate target of policy, and has no necessary bearing on the instrument problem. Contrary to Sargent's statement, it has been shown by McCallum (1981, 1986) and Friedman (1988) that an interest rate rule can in fact determine the price level, provided it is specified to target some nominal variable, such as money or prices. However, the literature gives little guidance on how such an interest rate policy rule might be conducted, other than at a fairly informal level.

This paper aims to provide a systematic treatment of the main issues concerning interest rate rules, using a relatively simple but rigorous model. The main questions to be addressed are as follows:

1. Under what conditions can an interest rate rule tie down the price level?
2. When are interest rate rules superior to money rules?
3. Can “rules of thumb” be devised for interest rate policy, corresponding to the simple money growth rules proposed by monetarists?
4. Should prices or nominal GDP be targeted?
5. Should targets be subject to base drift (i.e. taking actual outcomes, as opposed to target values, as the base point for projections)?

Many of the conclusions reached in the paper should be intuitively quite obvious, and some have appeared in earlier work, particularly by McCallum and Friedman. Also, an informal discussion of the topic has recently been given by Morris (1988). The paper's main intended contribution is in presenting a unified treatment of these issues in a formal theoretical framework.